1. Chapter 11 Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons 11-1

2.  Pervasive and dominant  The single most important risk affecting the price movement of common stocks ◦ Particularly true for a diversified portfolio of stocks  Can account for 90% or more of the variability in a well diversified portfolio’s return  Investors buying foreign stocks face the same situation 11-2

3. Two step decision process:  Asset Allocation ◦ % of portfolio wealth allocated to various asset classes such as stocks, bonds and cash ◦ This decision is the main factor in determining the risk and return of the portfolio. ◦ Our discussion assumes 100% of assets in common stocks  Security Selection 11-3

4.  Natural outcome of a belief in efficient markets ◦ No active strategy should be able to beat the market on a risk-adjusted basis over time  Aim to do as well as the market ◦ Emphasis is on minimizing transaction costs and time spent in managing the portfolio ◦ No attempts to time market or find undervalued stocks ◦ Expected benefits from active trading or analysis less than the costs 11-4

5.  Buy-and-hold strategy ◦ Belief that active management will incur transaction costs and involve inevitable mistakes ◦ Important initial selection needs to be made ◦ Investors still must take some actions  Reinvesting portfolio income  Adjusting to changes in risk tolerance 11-5

6.  Index funds ◦ Mutual funds designed to duplicate the performance of some market index ◦ No attempt made to forecast market movements and act accordingly ◦ No attempt to select under- or overvalued securities ◦ Low costs to operate, low turnover 11-6

7.  Index funds ◦ Offer tax efficiency ◦ Can come in form of ETFs, enhanced ETFs ◦ Historical averages show index funds generally outperform actively managed funds 11-7

8.  Assumes the investor possesses some advantage relative to other market participants ◦ Superior information, analytical skills, ability to do what other investors cannot ◦ Most investors favor this approach despite evidence about efficient markets  Potential rewards are large as are potential risks 11-8

9.  Traditional strategy is to select individual stocks ◦ Majority of investment advice geared to selection of stocks  Investors focus on EPS forecasts  Growth stocks and value stocks ◦ Value stocks “cheap” relative to earnings ◦ Growth stocks emphasize expectations of earnings growth  Value investing takes long-term, sometimes contrary approach 11 -9

10.  Security analyst’s job is to forecast stock returns  Sell-side analysts: reports used to “sell” idea  Buy-side analysts: employed by money management firms ◦ Research typically only available to their employers  Estimates provided by analysts ◦ Expected performance, earnings estimates, price targets ◦ Recommendations: Buy, Hold, or Sell 11 - 10

11.  Recommendation changes can affect stock prices  Analysts focus on forecasting earnings ◦ Typically overly optimistic ◦ Analysts rarely recommend selling  Analysts generally good at analyzing industries  Good independent info sources available ◦ Value Line Investment Survey, S&P’s Outlook, Morningstar 11 - 11

12. Number of Analyst Recommendations by Type for the S&P 500 Stocks Sell/Underperform Hold Buy/ Outperform 1,0006,0003,000

13.  Involves shifting sector weights in the portfolio ◦ Benefit from sectors expected to perform relatively well and de-emphasize sectors expected to perform poorly  Four broad sectors: ◦ Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and defensive stocks  Subject to greater risk than investing in overall market  Can be pursued with sector mutual funds, ETFs 11-13

14.  Market timers attempt to earn excess returns by varying the percent of assets in equity securities ◦ Shift into cash when stocks expected to do poorly, into stocks when stocks expected to do well  Success depends on the amount of brokerage commissions and taxes paid  Research suggests market timing is risky ◦ Investors may not be in market at critical times and may miss out on returns 11-14

15.  If stock market is efficient, prices reflect fair economic value ◦ Active strategies are unlikely to be successful over time after all costs  Proponents of efficient market theory argue that little time should be devoted to security analysis ◦ Time spent on reducing taxes, costs and maintaining chosen portfolio risk  Investor’s beliefs will affect strategy implemented 11-15 Rational Markets and Active Strategies

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